Product innovation (including in pooled investment vehicles) is encouraged, but innovation must be consistent with the law.
The US Commodity Futures Trading Commission’s (CFTC’s) Division of Swap Dealer and Intermediary Oversight (DSIO) Director Joshua B. Sterling issued a statement on February 10, 2020, supporting responsible digital asset product innovation, including pooled investment vehicles seeking exposure to digital assets and digital asset derivatives. The statement included an offer to assist innovators with the evaluation of new digital asset products that may not be subject to existing National Futures Association (NFA) disclosure and document review requirements.
Operators of pools that trade futures and options, swaps, or leveraged transactions referencing commodities (including digital assets such as Bitcoin and stablecoins) are required to register as commodity pool operators (CPOs) and must comply with attendant disclosure, record-keeping, and reporting requirements (unless otherwise exempt). Regardless of whether CPOs are exempt from supervisory oversight by the CFTC, they remain subject to the anti-fraud provisions of the Commodity Exchange Act when they market and offer interests in commodity pools to investors, in addition to regulatory and enforcement authority by the US Securities and Exchange Commission.
NFA Requirements Regarding Disclosures in Digital Assets
In addition to existing CFTC and NFA disclosure requirements for CPOs, the NFA issued rules in October 2018 requiring heightened disclosures for CPOs (and other intermediaries) engaged in virtual currency trading, whether as derivatives transactions or spot trading. (See Effective October 31, 2018: New NFA Virtual Currency Disclosure Requirements.) For commodity pools that include virtual currency spot trading, the NFA prescribed specific disclosure language as well as customized disclosures tailored to the activities of such pool. For commodity pools that include virtual currency derivatives, customized disclosures tailored to the activities of such pool must be communicated prior to accepting an investment from any solicited prospective investors. Customized disclosures are expected to be robust, and should address the unique risks related to the CPO’s particular offering and activities. These risks are not static, but may vary on a case-by-case basis depending on the type of offering or activity, and may even vary over time for the same offering or activity, due to intrinsic or extrinsic developments affecting virtual currencies.
A Disclosure Checklist for CPOs Offering Digital Assets
For CFTC-registered CPOs, the DSIO’s statement includes a reminder that disclosure documentation must precede any offering of the pool’s interests to investors, for review and approval by the NFA. Disclosure requirements focus on risk, returns, and related expenses. Such disclosures include (but are not limited to):
- Strategy Disclosure: Accurate characterization and context of a commodity pool’s investment strategy
- Risk Disclosure: Accurate characterization of the opportunity for gain or risk of loss in the commodity pool’s underlying assets and financial instruments, whether tangible or intangible in nature
- Expense Disclosure: Accurate disclosure of a commodity pool’s fees and expenses
- Principal Disclosures: Accurate characterization of the business and educational qualifications of the key principals who oversee the CPO’s trading strategy for such commodity pool
- Discussion of Commodity Brokers and Trading Counterparties: Accurate disclosure of a commodity pool’s brokers and trading counterparties
Against the backdrop of existing disclosure requirements and the NFA’s heightened disclosure requirements for virtual currency investments and trading, market participants should carefully review their disclosure materials with counsel to ensure they are in compliance with current regulation and market practice.
Disclosure Violations Are on the CFTC Enforcement Radar
The CFTC has been actively pursuing enforcement actions against entities and CPOs that engage in fraudulent activity, make false disclosures, misrepresent risk to prospective clients, and fail to appropriately register with the CFTC.
- On February 14, 2020, the CFTC brought charges against an entity for fraud and failure to register as a CPO. The entity in question purported to trade foreign currency (forex) contracts as well as Bitcoin and other digital assets through an unregistered commodity pool, made false and misleading disclosures to customers, and used investors’ money for personal gain and Ponzi-type payments to other investors.
- On February 13, 2020, the CFTC charged an individual with soliciting investor funds for an unregistered pooled investment vehicle purportedly trading commodity futures contracts. The individual made false or misleading statements regarding the risks and returns of his trading to prospective and current pool participants, while misappropriating funds for personal use.
- Similar charges were issued against related defendants on February 11, 2020, for making false and misleading disclosures to investors to solicit funds to purportedly trade digital assets. Defendants, in fact, were never registered with the CFTC, and fraudulently misappropriated investor money for personal use.
- On January 27, 2020, the CFTC brought charges against a registered CPO (and its CEO) for making materially misleading statements regarding its risks and risk-management measures, leading to approximately US$500 million in investor losses.
In all these cases, the CFTC reiterated that the registration and disclosure requirements in place for CPOs are critical to ensuring market integrity and investor protection. The DSIO statement and offer of assistance to market participants is a reminder that the CFTC will actively support responsible innovation, which by all indications of recent enforcement trends means that it will not tolerate non-compliance with disclosure and registration requirements.